Should dividend stocks be treated as a separate asset class?

Dividends are a major component of total return. Over the past 80-odd years, they have accounted for more than 40% of the return of the S&P 500 and its predecessor index. And in periods of market decline -- the 1930s and the first decade of this millennium come to mind -- dividends provided the only returns that stock market investors saw.

But few advisors consider dividend-paying stocks as a separate category. Perhaps the last thing that advisors want is another asset class to have to add to the portfolio mix. Yet in aggregate, this asset is easy to access, has been around as long as stocks have, and has demonstrable portfolio-enhancing characteristics.

OUTPERFORMING NON-PAYERS

Studies have shown that dividend-paying equities tend to outperform non-payers over time. Companies that increased dividends provided a 9.46% annual return -- vs. 6.98% for stocks with constant dividend payments and a 1.48% annual return for non-payers -- from December 31, 1972 through June 30, 2012, according to a study last year by Ned Davis Research, an institutional research firm. The returns were based on the monthly equal-weighted geometric average of total returns of S&P 500 Equal Weight Index component stocks, with components reconstituted monthly.

Other studies have shown that dividend-paying stocks can be less volatile. A study focused on the 1987 stock market crash found that on Oct. 19, when the Dow plunged 22.6%, dividend payers declined one-third less than non-payers.

One possible reason for the stability: Investors who hold dividend stocks can look forward to another cash payment, usually within 90 days. In contrast, those who buy “hot” stocks that don’t pay a dividend are more likely to cut their losses if the share price retreats. (After all, one reason to hold the stock -- near-term gain -- has already failed to pan out. Why hold a loser?)

BUFFETT STRATEGY

Any discussion of dividends usually comes around to Warren Buffett -- whose company, Berkshire Hathaway (BRK), famously does not pay them. Yet Berkshire Hathaway has delivered great returns for its shareholders, in part because while Buffett may not like to pay dividends, his company likes to receive them.

In 2013 alone, dividends from Berkshire’s top four holdings -- Wells Fargo (WFC), Coca-Cola (KO), American Express (AXP) and IBM (IBM) -- added more than $1 billion in cash to the company’s coffers. Your clients won’t have assets in the same league as Berkshire Hathaway, but they can benefit from holding either individual dividend-paying stocks or the funds and ETFs that focus on them, as part of a balanced portfolio.

Which is not to say that all equity holdings should be dividend payers. Since most dividend payers are large cap and large-cap stocks are about 75% of the domestic stock market, reallocating 65% to 70% of the U.S. equity allocation to dividend-paying issues would not be out of line.

Nor would it be prudent to substitute dividend-paying stocks for the high-quality bonds that provide ballast to a portfolio. But in an era of low fixed-income yields, dividends can provide needed income for older clients. And younger clients who own stocks that regularly increase their dividends will be well on their way to a more secure retirement.

Admittedly, dividend stocks can mean more work for the advisor. If you are using individual issues, there’s a great deal of research involved. Even funds based on dividend payers tend to be mostly large-cap stocks. That means more work in balancing the portfolio. And you will have to explain the strategy to the client.

Dividend strategies are a slow way to accumulate wealth. But after all, Aesop’s tortoise did beat the hare.

Read more: